*2.3.1.3 Market risk*

*Banking and Finance*

measurement approach.

the operational risk.

in the operational areas are permitted to follow the standardized or advanced

Here KBIA is the capital charge in basic indicator approach; GI is the gross income, which was positive, over the previous 3 years; n is the number of previous 3 years for which gross income is positive; and α is 15% required capital level against

In standardized approach, a bank's activities are divided into eight sectors: corporate finance, trading and sales, retail banking, commercial banking, payment and settlement, agency services, asset management, and retail brokerage. In standardized approach, for every sector separate gross income is calculated separately. To measure the capital charge, this sectoral gross income is multiplied by denoted beta (a factor). Beta is a proxy variable that denotes relationship between the operational risk (of loss) for the particular business sector and aggregate level of gross income for that business sector [5]. Unlike basic indicator approach, standardized approach

In SA, capital charge is calculated by taking the 3 years average of simple summation of the regulatory capital charge for each of the business sectors. Any negative capital charge due to negative gross income for any business sector may offset the positive capital charge in other business sector without limit. If the aggregate capital charge across all business lines in a certain time period is negative, then the numerator will be considered as zero. BCBS expressed the equation as follows:

where KSA is the capital charge under the standardized approach; GI1–8 is the annual gross income in a given year, for each of the eight business sectors; and β1–8 is a fixed percentage, set by the BCBS, the level of required capital to the level of

**Table 1** presents the value of β for each business sector as prescribed by BCBS

**Sl. no. Business sector Value of β (%)** Corporate finance 18 Trading and sales 18 Retail banking 12 Commercial banking 15 Payment and settlement 18 Agency services 15 Asset management 12 Retail brokerage 12

KSA = {ΣYears <sup>1</sup>–<sup>3</sup> max [Σ(GI1–<sup>8</sup> X β<sup>1</sup>–8),0]}/3 (3)

calculation of capital charge in basic indicator approach is as follows:

measures capital charge for each business line separately.

the gross income for each of the eight business sectors.

In basic indicator approach, the capital charge for operational risk is equal to the 15% of average positive annual gross income of the bank. Gross income is the total of net interest income and net non-interest income. It does not include any realized profit or loss from the sale of securities and any income derived from insurance. The

KBIA = [Σ(GI1…n × )]/n (2)

**8**

**Table 1.**

*Value of β for different business sectors.*

[5] as follows.

BCBC defines market risk as "the risk of losses in on- and off-balance sheet positions arising from movements in market prices." Sources of market risk are interest rate risk, foreign exchange risk, and commodities risk [5]. Interest risk arises from the loss due to movement of interest rate. Foreign exchange risk arises from changes in banks' assets and liability due to the fluctuation of foreign exchange rate. In the case of cross-border investments, when banks invest in different currencies risk arises due to adverse changes in the exchange rate. Similarly, commodity risk arises from the uncertain future market price changes in commodity prices.

Market risk is measured using the standardized measurement method and value at risk (VaR) or internal model approach. The choice of method is subject to the permission of the regulatory authorities. In standardized measurement method, four risks are addressed which are interest rate, equity position, foreign exchange, and commodities risk. The practice of internal model approach is subject to compliance of certain conditions and approval of the supervisory authorities.

Therefore, bank's total minimum capital requirement will be the summation of the capital requirement against the credit risk, capital charge for operational risk, and capital charge for market risk of the bank.

#### *2.3.2 Pillar II or supervisory review process (SRP)*

Pillar II or supervisory review process intends to assure that the bank has sufficient capital to support different risks arising in the business operation as well as encourage developing and practicing better risk management technique. SRP concedes the bank management to set capital target through developing an Internal Capital Assessment Process (ICAAP) that commensurate with banks own risk profile [5]. It also ensures that the bank management bears the responsibility to maintain the adequate level of capital beyond the minimum level to support its risk. The committee identifies the appropriate relationship between the risk and amount of capital and the effectiveness of bank's internal control and risk management process. The role of supervisory authority is to evaluate how the operating banks are assessing their risk and capital requirement and intervene if necessary. SRP intends to intervene the bank regulators to prevent capital shortfall from the minimum level in the early stage and to take rapid corrective action [5]. The SRP takes into account other risk factors that are not considered in Pillar I (i.e., liquidity risk and interest risk). The regulatory authority evaluates the bank's assessment of capital, ability to monitor, and be compliant with the capital regulations.

#### *2.3.3 Pillar III or market discipline*

Pillar III promotes market discipline through a set of qualitative and quantitative disclosure requirements that allow the market participants to understand the scope of application, capital position, risk exposure, and assessment of the banks. It is complement to Pillars I and II. Therefore, the disclosure allows a bank to present its risk position that is based on a common and consistent framework to the regulatory authority as well as public for comparison and credibility.

Bank supervisors having their power to disclose requirements to the operating banks contribute to safe and sound banking practices. Banks will have a formal disclosure policy approved by the board of directors, which exhibits the items to be disclosed, frequency, and internal control over the process. These capital and risk disclosure requirements do not conflict with and minimize the scope of the accounting requirements.
